Afterpay: buy now, regret later?

<p><strong>Lex Hall: </strong>Hi, I'm Lex Hall for Morningstar and welcome to another edition of "Ask the Expert." Today's subject is Afterpay, the buy now, pay later company that's become a household name and had an incredible run since it first listed on the Australian Stock Exchange in 2017. And with me today to talk about it is Morningstar analyst, Chanaka Gunasekera, who began coverage of it this week.</p>
<p>Good day, Chanaka.</p>
<p><strong>Chanaka Gunasekera:</strong> Hi. How are you doing, Lex?</p>
<p><strong>Hall: </strong>Good. I'm well. Thanks. Now, Afterpay listed, as I said, in June 2017 at the price of $2.95. Today, it's worth more than $32. That's a rise of 1,000%, putting it into sort of 10-bagger, that mythical 10-bagger status. Before we get into the incredible run, how does the model work? Can you just run us through that?</p>
<p><strong>Gunasekera:</strong> Sure. It's a buy now, pay later model. And so, a customer would go into a merchant, say, Harvey Norman or another merchant and want to buy something. Usually, the sale price on average is about $150. They will go there, and at the point-of-sale terminal, they will get their mobile phone with the Afterpay app, get the Afterpay app downloaded, and then buy the product and initially, they will pay a 25% installment. And then over the next two weeks, they will pay 25% each two weeks until they pay off the amount. And they'll pay nothing to Afterpay if they pay on time. If they are late, they may get a late fee. But primarily, Afterpay gets paid by the merchant via a margin.</p>
<p><strong>Hall: </strong>And they've got, I think, it's 3.5 million Australians using it and about 28,000 shops they say?</p>
<p><strong>Gunasekera:</strong> Yeah, they've had a rapid growth in customers as well as merchants. It's really resonating with both customers, primarily the millennium customer, the younger market. And also, because merchants are saying that their customers are buying more and transacting more frequently and by higher dollar value amounts, merchants are attracted to it as well.</p>
<p><strong>Hall: </strong>Because it allows them to move more stock as well?</p>
<p><strong>Gunasekera:</strong> Correct. Yes.</p>
<p><strong>Hall: </strong>And it's a modern form of laybuy, something that's been around for a long time, right?</p>
<p><strong>Gunasekera:</strong> Yeah, sort of digital form of laybuy, except for the fact that you get the product straightaway.</p>
<p><strong>Hall: </strong>OK. And part of the growth is tied to their expansion overseas, I understand?</p>
<p><strong>Gunasekera:</strong> Yes, the US and the UK are probably going to be their near-term growth drivers. They've been in the US for about a little bit over a year now and they've had significant growth. Their growth in the US, finance sales growth, has been at a faster rate than they experienced here in Australia.</p>
<p><strong>Hall: </strong>OK.</p>
<p><strong>Gunasekera:</strong> Initial results in the UK. &ndash; they've been in the UK for about 15 weeks, or a little bit more, and they're growing clients strongly there as well. So, the initial &ndash; it's only early days, of course, in the UK, but its growth is strong there as well.</p>
<p><strong>Hall: </strong>And just to give you an idea of the growth, its growth trajectory, it's $2.2 billion in financed sales in 2018. That's more than doubled to $5.5 billion in financed sales in 2019. And fiscal 2022, they're aiming for&hellip;?</p>
<p><strong>Gunasekera:</strong> $20 billion plus.</p>
<p><strong>Hall: </strong>$20 billion plus. That's a pretty, pretty&hellip;</p>
<p><strong>Gunasekera:</strong> Massive growth. Yes, exactly. And that's why it's getting a lot of traction by investors I suspect.</p>
<p><strong>Hall: </strong>OK. Let's get to your valuation. It's over $32 today. You've got at $22. It's a 2-Star stock.</p>
<p><strong>Gunasekera: </strong>Yes.</p>
<p><strong>Hall: </strong>What are your reasons for it being overvalued like that?</p>
<p><strong>Gunasekera: </strong>We think it's going to experience significant finance sales growth. However, there's some material business risk it also faces. I think first of all is near term there's going to be some more direct competition towards buy now, pay later product. You're seeing that in organisations like FlexiGroup. They're introducing two new buy now, pay later products, which are likely to compete directly with Afterpay's. You're seeing overseas companies like Klarna, the Commonwealth Bank recently invested US$100 million in Klarna.</p>
<p>And then, more recently, in the last few days, Latitude teaming up with Harvey Norman to introduce another buy now, pay later product, and they're going to compete very heavily on the merchant fees. So, those are near-term risks. And also, they rely heavily on the equity and debt markets to find strong sales growth. Now, they've got support from the equity market, primarily because they've been growing so strongly. But obviously, if they don't meet growth expectations, then that could be a risk. And also, because they're growing customers, retail customers, rapidly, they're also seeing a fair bit of scrutiny regulators, the most recent being AUSTRAC, which has asked them to appoint an auditor to look at their &ndash; any money laundering and risk management processes. So, that's a report that's going to be announced very shortly.</p>
<p><strong>Hall: </strong>OK. And what's Afterpay doing to sort of combat those rivals? I understand it's in a tie-up with Visa.</p>
<p><strong>Gunasekera: </strong>Yeah. It announced only very recently that in the US they've signed an agreement with Visa. They haven't really provided much detail about that yet. It was only announced a few weeks ago at their earnings announcement. So, there's very scant detail on that. In relation to competition, what they're trying to do now is grow scale rapidly. And so, what they're focusing on is the enterprise, the larger merchants who have more customers. Now, the problem with that is that those large merchants, they could charge those merchants a lower fee. So, it's probably less than 3 per cent, whereas the small to medium businesses, they can charge a higher fee, 4 per cent plus. So, yeah.</p>
<p><strong>Hall: </strong>Right. And just getting back to that merchant fee and the tie-up between the Latitude and Harvey Norman, I think you were saying that they're aiming to sort of take on Afterpay by charging a very low fee.</p>
<p><strong>Gunasekera: </strong>Correct. Yes. Very small amounts, very low indeed. And so, in fact, I think it's going to be free for a period of time. So, they are competing very strongly with that. The other thing, the difference with &ndash; it's only just been announced, but the difference from what I can read is that also they're going to be subject to Consumer Credit Code, and so they're going to provide more credit checks than Afterpay is providing currently.</p>
<p><strong>Hall: </strong>And despite this astronomical growth, they're still not making a profit as far as I understand.</p>
<p><strong>Gunasekera: </strong>Correct. Yeah, they made a loss this year as well. And so, we expect they'll make a loss &ndash; sorry &ndash; made a loss in 2019, last financial year, and then, I suspect they'll make a loss this financial year as well and be profitable in the following financial year.</p>